Real estate is a no-no in the current slowdown scenario

Real estate in India has bucked a trend of non-performing asset classes. Property prices have outperformed equities, currency and bonds by a wide margin.

Investors buying property have increased over the last few years and this has increased the supply of rental properties.Reuters

Going by India's real estate market performance, one would be inclined to conclude that India is actually not seeing any economic slowdown and any statistical number thrown up on GDP growth is just plain statistics. India's GDP growth for the fourth quarter of 2011-12 came in at a nine-year low of 5.3 percent, taking down the full year's growth to 6.5 percent from levels of 8.4 percent seen in 2010-11. Economists are busy revising GDP forecasts from above 7 percent levels to levels of 6.5 percent and below for 2012-13.

Table 1 below shows the performance of various asset classes in India over a two-year period from June 2010 to June 20212.

Source:Bloomberg, magicbricks.com

In fact a disturbing trend emerging with the general investing public is that while India's equity, bond and currency markets will reflect the poor show of the economy and reflect the global issues of debt crisis in the eurozone and the property bubble bust in China, the real estate market will continue on its upward trend.

First-time home owners are busy exhausting savings and pledging gold and other assets to buy property while single homeowners are buying their second and third homes or even land in the belief that property is the best investment going around.

When it hits, it hits hard

Will the trend of real estate outperformance continue going forward? The factors that go into driving real estate prices are definitely negative and will continue to remain negative going forward. The factors include lending rates and terms, price-to-income ratios and rental yields. Taking each by turn.

Bank lending to real estate is facing headwind. On a consumer level, interest rates have gone up by at least 300 basis points (3 percent) over the last couple of years while loan-to-value ratios (LTV) have come down from 90 percent to 80 percent and below. Consumers will have to put in more upfront money to take a loan at a higher interest cost given the rise in interest rates and decline in the LTV ratio.

The fact is that in a slowing economy income levels have not kept pace with the rise in property prices. Income levels in the economy are rising at low double-digit levels for those who can actually think of buying property, while property prices are expected to go up by at least 25 percent every year.

Labour market trends indicate that the financial services sector is shedding jobs while the IT sector is increasing headcount but at the entry level. Entry level employees cannot afford to buy houses in India as the price-to-income ratio will be a minimum of 10 times. Hence, even as property prices have moved up and lending terms have become tighter, the affordability factor has actually gone down.

Rental yields are abysmally low, in the range of 2-3 percent across metros. Despite the rise in interest rates, the rise in inflation and the rise in property prices rentals are staying sticky at lower levels. The reason is that investors buying property have increased over the last few years and this has increased the supply of rental properties.

There is also resistance to paying higher rents by tenants due to the economic slowdown. Rental yields at 2-3 percent compare unfavourably with fixed deposit rates of 8-9.25 percent. Unless capital gains can make up for the 6-7 percent differential, property will not be a paying proposition for investors.

China is a good example of a booming property market going bust. China's property prices moved up by over 60 percent over the 2007 to 2010 period even as its stock market fell 50 percent from highs in the same period. Bank lending as a percentage of GDP to mortgages rose from 12 percent to 16 percent over the same period. China is now fighting to keep down bad loans of banks as property prices have fallen for the ninth straight month in May 2012. Investors in China, who were under the impression that whatever happens to the economy, property prices will not fall, have received a rude shock.

Investors in Indian property markets are betting on a revival of the economy. However, given that there are markets that have actually corrected on the back of an economic slowdown, any revival will first see a sharp uptick in the prices of equities. Property will lag equities as the markets have already factored in economic revival given that property prices have gone up in the face of an economic slowdown.

If the economy continues to flounder, property investments will start showing negative returns. Given the opaque nature of the real estate market and the risk of liquidity in terms of buy-sell spreads and legal risks in terms of title, etc, a further downturn in the economy will hurt property investors badly.